We established a position inNetflix (NASDAQ:NFLX) yesterday after the stock crashed 35%. We will discuss it at greater length in our monthly letter next week, but in case you read about it before then, we wanted to assure you that we haven’t lost our minds. We simply think it’s a good company and that the market has over-reacted to all of the recent negative news, thereby providing us the chance to own it at a cheap price.

Given our unsuccessful timing of being short this stock – a highly frustrating experience – we’ll admit that it was hard to overcome the emotional baggage and think about Netflix with a fresh perspective, but as we wrote to you in last month’s letter, for every investment decision, we simply ask ourselves: if we were starting our fund from scratch today and held only cash, what would we do? In this case, the answer is that, at this price, we’d own Netflix.

Netflix today reminds us of BP 16 months ago (and we all know how well that worked out): the company, its CEO and the stock are all universally hated right now, with endless headlines of furious customers and shareholders. We love situations like this – as long as we’re convinced that there’s a good company and a cheap stock once you cut through all of the noise.

And we do think Netflix is a good company – even when we were short it. The problem wasn’t the company, but rather the extreme valuation of the stock – but now that it’s down nearly 75% from its peak less than four months ago, the valuation is downright cheap in our opinion.

The article below captures many of the reasons we’re bullish. In addition, we’d add the following:

• We think Netflix can earn $5-6 of contribution margin per customer per month (a bit less than half of average revenue of approximately $12.50). This translates into $1.3-$1.7 billion of operating profit (excluding Netflix’s nascent international operations), for a company with a market cap today of just over $4 billion.

• With 23.8 million subscribers (again, excluding 1.5 million international ones), Netflix is being valued at $175/subscriber, a very low figure relative to other media companies.

• We think Netflix was smart to raise its price – our only quarrel is how Reed Hastings communicated it. We wish he’d send the letter below to them, explaining the reasons for this action. Note that the price increase only affected subscribers who were getting both the streaming and DVD services (they were paying $9.99 and now have to pay $7.99 for each service, a 60% price increase). Streaming-only and DVD-only customers didn’t see a price hike and these subscriber numbers are growing quickly, especially the streaming-only, which is the future of the company. Based on the company’s guidance and our own estimates, we think that the number of streaming-only customers will rise 29% from 9.9 million at the end of Q3 to 12.8 million at the end of Q4, due to both new subscribers as well as current streaming and DVD customers dropping the DVD portion. The net result is that the total number of subscribers will remain roughly flat in Q4, but the mix will shift to more streaming and fewer DVD customers (who will be far more profitable, thanks to the price hike). We think these trends bode well for the company over time.

• Its shrunken market cap means that Netflix would be a bite-sized acquisition for any number of much larger companies like Apple ($370B market cap), Google ($188B), Amazon ($93B) or Disney ($64B).

About the author:

Jacob Wolinsky

My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Comments

I largely agree with Tilson here, and I think that Netflix will eventually be a great buy. The problem is that the stock is currently in a no-man's land. Growth / momentum investors are dumping it, but it's not quite cheap enough to attract value investors.

Why would NFLX be purchased by anyone. The contracts for content would have to be renegotiated in short term so nobody knows what the actual content acq costs will be. If NFLX had very long-term, below market value content contracts that were long-term, then maybe it would be worth it but they have to re-up on the new content. Not to mention a number of companies already have the same content and the infrastructure is already set. For example, if you use AMZN Prime, it's $80/year for free shipping and you get a bunch of content free to stream that is exactly the same as NFLX.

NFLX's value and success depends on defending its moat. It has no technological barrier. Cable cos are offering similar $8-9/mo offering to customers to watch similar content as NFLX. And then there's no content barrier, any of these companies that NFLX competes with already have similar content - go check out AMZN Prime video offerings. All middle men like NFLX will get disintermediated, Paramount for example is circumventing everyone and going straight to IP distribution. The bigger guys are charging the same or less for what NFLX streaming offers. You can basically just wait for NFLX to churn more customers and poach them rather than overpay at this level.

AAPL already has the infrastructure ready for iTV or iHome and can do the same thing, acquire the content they want and stream it.

Tilson is in over his head, he should stick to dumpster diving outside of Greenlight and Pershing Square.

Here is an excellent presentation by Whitney on Behavioral Finance. One of the points is "Anchoring on Past Data". I think the following line in the letter above is an example of "Anchoring"

And we do think Netflix is a good company – even when we were short it. The problem wasn’t the company, but rather the extreme valuation of the stock – but now that it’s down nearly 75% from its peak less than four months ago, the valuation is downright cheap in our opinion.

The peak was an overvalued price as most will agree including Whitney since we was short it much earlier. So, who cares if its down 75% from an insanely over valued level. That does not make it cheap.... Yes, thats not his thesis by itself...

The reason I point it out...is I have often been guilty of thinking along the same lines that the stock is down 50% from its former peak or all time peak...well that's just a data point ...nothing else...

I have the following points ( Hat tip to Walter Lu)

1) From March 2011 to Sept 2011, Account Payables went from $300 million to $750 million. In the same period, Sales went from $718 million to $821 million. Why are Payables rising so fast? Are those the content costs that keep going up as you said they would ?

From the 10-Q The Company had $3,458.9 million and $1,123.4 million of obligations at September 30, 2011 and December 31, 2010, respectively

2) What is the Free Cash Flow that Netflix produces currently? How would it look like as these costs go up? From my calculation, FCF last year was $110m

I wouldn't say that the rebuttal by Slim Shady at Seeking Alpha is very solid. That author has only posted 4 articles on Seeking Alpha, including two bashing Warren Buffett on some tax issues, and he/she made a serious mistake in their compuation (refer to my blog post from a while back to see what I mean:

http://can-turtles-fly.blogspot.com/2011/08/is-netflixs-streaming-model-uneconomic.html ). Basically, the author assumes that the LIFETIME profit of a subscriber is $9 and repeats that value in the article you cite. Based on this he/she concluded in the original article that Netflix needed 1.6 billion customers, which is clearly nonsensical (the notion of earning $9 over the life--say the life is 20 years for a going concern business--is almost silly).

Because of the huge error with the $9 lifetime profit figure, I think some of the other comments by Slim Shady about the economics of the business cannot be relied upon. Furthermore, I think Slim Shady conflates the differing nature of streaming video and the mail-DVD business. The characteristics are completely different. For instance, you can't assume that a $1 profit for streaming is sort of the same as $1 profit for mail-order. The profit margins on streaming should be far higher--think about the fact that it has no shipping cost and the Internet service cost is paid by the subscriber on their own--and it is obvious that the characteristics are different. It's kind of like e-books vs physical books. The sale price for e-books is typically lower but that doesn't mean that it is necessarily worse off (Amazon, for instance, is not making less money now that it is selling more e-books than physical books in some categories). If Netflix can successfuly transition to streaming, its profit, profit margins and return on equity can be higher even if revenue declines!

I am starting to look deeper into Netflix as a potential (long) investment, and I don't see anything that suggests that the business model is uneconomic. The big risk in my eyes is not what is generally discussed by the bears but, instead, is the possibility of ISP throttling bandwidth (to favour their own traffic) or charging based on bandwidth. Unless the government blocks this, Netflix's users are vulnerable (streaming can be uneconomic if ISPs charge a high rate per megabyte). Anyway, Netflix is still not cheap but it is getting there.

I agree with that but I don't believe that is what Netflix will rely on. The big barrier that Netflix can capitalize on--who knows if it will actually succeed--is network effects. Like most Internet services, network effect can be a huge barrier! If Netflix can maintain loyalty, word-of-mouth alone would be a huge barrier. Although a different line of business, one could have argued that there is no reason Facebook, which has no technology advantage, should be so dominant. Yet it is. Same possibility can materialize here, although Netflix has to execute.

AMIT: "All middle men like NFLX will get disintermediated, Paramount for example is circumventing everyone and going straight to IP distribution."

That is a big challenge for Netflix but the (negative) outcome isn't as obvious to me. It will come down to who can do things most efficiently (i.e. cheaply) and maintain strong customer service or quality. If you look at television content distribution in the past few decades, the middle-person, such as television stations and cable stations, actually did very well because they aggregate content. Similarly, people shope at a multi-line clothing store because it aggregates products. If consumers want a one-stop-shop, then companies like Netflix (and others with similar business models like Amazon) will do well. In such a scenario, the content creators selling through their own channel wouldn't be a big threat (yes, you will have niche markets--like HBO selling only through its website--but the mainstream will be the one-stop-shop).

As for cable/satellite/etc companies provding the same product, do keep in mind that they lost the battle in the past in the traditional mail-order or rental DVD business (i.e. Netflix mail-order and Blockbuster physical store). The content the cable companies (and others) offered was somewhat similar to Netflix and Blockbuster but they just couldn't compete. I'm not saying they won't succeed this time around but it's not as straightforward as it seems.

Having said all that, I think Netflix faces some big challenges so it isn't a safe investment, if one is thinking about it, by any means. I have to do more research but I think the biggest threat to Netflix is the possibility of ISPs throttling bandwidth (to favour their own entities or favoured parties) or charging Internet usage by bandwidth. Such an outcome could seriously hurt the viability of the business model.

They have to pay a lot more for content in the streaming world. They cannot re-use like in DVDs as its protected by the First Sale Doctrine. Check the content costs for streaming and the off-balance sheet liabilities..

ADIB: "They have to pay a lot more for content in the streaming world. They cannot re-use like in DVDs as its protected by the First Sale Doctrine. Check the content costs for streaming and the off-balance sheet liabilities.."

I'm starting to look deeper into the company but on the higher streaming costs, it's not clear that it makes streaming unviable. Streaming is more similar to broadcasting--think of television broadcasting of movies--so clearly the First Sale Doctrine wouldn't apply. Yet, television broadcasters still made a living broadcasting movies over the air. Internet streaming would probably develop in a similar manner in my view. So, I am not sure it necessarily makes streaming uneconomic.

As for the other point about off-balance-sheet liabilities, I'll post my views after looking into into it in more detail. I remember some bears making that comment an year or two ago but it wasn't clear to me at that time--I never looked at the company in detail--whether it was an issue. The question ultimately will be whether the company can cover these liabilities. If they keep growing and earning a decent return then they will be fine.

I think its important to understand how movie distribution works. Over each cycle of distribution, a film is sequentially distributed in a way that "maximize" the revenues for the studios. (From Dreamworks S-1 prospectus)

Television broadcasters make a living (the free-to-air ones) by ad revenues, not by subscription. So, the comparison is inappropriate. They are literally the last ones in the distribution sequence - this is where studios make the least but y then they have squeezed every dollar they could.

Given above chart, let's think about this - if you were a studio with a highly successful movie - Avatar, Toy Story 3 - where would you place distribution to Netflix at? Would you put it prior to Pay-Per-View or after Pay-Per-View (Starz, HBO, Amazon, iTunes) ? Where do you think you will make the most $? I think you will agree that if Netflix is not going to revenue share with you per view of the movie you would rather that they come after pay-per-view. Next, do you think Netflix comes after Home Video (DVD sales)? I would think so, given the high margin business of a DVD sale. One could argue that DVD sales are falling, but this makes the case stronger for a studio to be hard on negotiating the best deal they can with Netflix. This also means streaming movies come after DVD rental (Coinstar before Netflix streaming).

Netflix realizes that streaming content is expensive, so they cut a deal to delay (link) releases by 45 days to let the studios make more money on DVD sales and in return get cheaper streaming content. This means new releases on Netflix DVD also comes after Coinstar DVD or Blockbuster DVD. Consumers (like my wife and I) who don't really care about long tail content are going to move to pay-per-view platform (Amazon, iTunes) to watch new releases as streaming.

For those who care about longer tail content will continue to find Netflix as an attractive platform, but as other alternatives become available (joint venture of studios like Hulu with more content), these customers will (or already are) clamor for more content on streaming and will move away from DVD. DVD is much higher margin business than streaming (irrespective of what eventually happens with the streaming model, it will most probably not be as attractive as DVD) causing today's margins to look like peak.

Maybe I am old fashioned, but I can't put my hat on what margins will look like in the future to a reasonable degree, I just consider the business too difficult to analyze and pass. Why would I want to pay 15x Forward P/E for such a huge unknown. If you listen to investor day transcripts of Disney, you will hear that even Bob Iger (who in my opinion is one of the smartest media executives today in addition to John Malone) doesn't exactly know how the windowing of film distribution (Disclosure: I own Disney) work in the digital world.

Sivaram - NFLX had a bigger advantage before streaming became so popular. The fulfillment infrastructure for DVDs is what made the co valuable in that that would be more difficult to replicate but now you really don't need it. Now if you are AMZN, iTunes, etc. all you need is your team to develop an in-house software/app that can be loaded on any smart blu ray DVD player or STB. You can buy blu ray players that now have AMZN video installed. As streaming becomes more popular, you may see more customers churn because you can get all of that same NFLX streaming content for free. If you are an AMZN prime customer, you dont need NFLX if you use it predominantly for streaming.

I agree re Cable/Telcos failing in the past but streaming has totally changed the game. Content is migrating online much faster, it's far easier for a cable co to offer something similar to NFLX for a similar or lower price. Most of the streaming content on NFLX is garbage or lower value content so acquiring those rights are easier. It's very easy for a cable co to offer some "portal" for paying subs to pick from content similar to what NFLX offers.

And as you said, net neutrality could be the biggest issue when it comes to long term success for competition. Other than that, i think Cable/Telcos are also a potentially great short. Many people pay for 3 or 2 services. I think IP distribution will be the way things go, tv sets now come installed with the ability to access the web directly w/o the bloatware. With higher bandwidth you can stream 1080 over the web. People will eventually not need "tv" subscriptions.

Just finished listening to John Malone's comments from Liberty's September annual meeting. Here is what he said: "The sequential distribution of movies has to go through various organisms in order to optimize value. Taking [your content] and dumping it in at wholesale on random-access basis [Netflix] really undermines long-term perceived value. As a content investor or owner, that's the biggest problem we have with the Netflix approach"

Thank you for the discussion. It definitely helps me in my investigation. Here are my thoughts on some points both of you raised.

First of all, I think the stock is still not attractive right now. Even if the business doesn't deteriorate, you are looking at a company that earns an FCF of around $250M and is currently trading around $4.5B. Even if you project in an above-average growth rate, the stock is nowhere near cheap. I would want to see the stock fall another 25% or so before it starts looking attractive. Having said that, it still appears to me that the business model isn't as weak as the bears are arguing.

I still have to do a lot more research on how Netflix is trying to position itself but my impression--and this goes to some questions raised by both of you--is that it is definitely a subscription-only business. This means, in my view, that it wouldn't necessarily compete directly against the pay-per-view models including those of some cable companies, Apple, and others.

In the model quoted by Rishi above, I would say this puts Netflix behind pay-per-view and more akin to home video. In the chart shown above, home video and pay-per-view (at least according to Dreamworks) starts at the same time but I suspect that the Netflix-type service would be delayed: it would be a new category that will be delayed slightly after pay-per-view (home video will become obsolete eventually so the market would be different).

Netflix could change their positioning any minute but all this means that they will be going for the long-tail. A customer like Rishi may not be in the target market for Netflix but the long-tail is far larger than the pay-per-view. For instance, a cheap guy like me, who is somewhat into movies, would find pay-per-view expensive and would likely go for subscription models even if they movies are back-catalog or delayed by 6+ months from theaterical release. I don't think the content companies will let a fixed subscription service like Netflix ever stream content right away; they also will charge a lot and this means Netflix likely won't have the same quality content that is possible on DVD.

Hence, the key differentiator that Netflix offers is that it is a fixed subscription service. They may offer premium subscriptions in the future but as long as it remains a fixed subscription service, it sets itself apart from the pay-per-view services (whether it's cable TV, iTunes, or whatever).

The problem for Netflix right now is that it is unclear what their profit margins (for streaming) will be. The margins are obviously not going to be like DVDs but lower margins can be ok if they have large volume. A company like Amazon has very thin profit margins but because its sales is high (like most retailers) its profit is fairly good--stock is still very expensive though. I'm not saying Netflix is a retailer but just pointing out that margins need to be considered in light of sales.

Netflix has more streaming customers now than DVD subscribers (I have to check but I believe it grew its streaming customers to the same level as DVD in a much shorter period of time). This probably means that higher growth is possible with streaming (as opposed to DVDs). If it can get to 40million subscribers in 10 years (roughly double present; around 13% of total US population in 10 yrs), you are looking at around $4b revenue. If profit margin can be maintained at 10%, the company is probably worth at least $4b.

I know I'm throwing in a lot of 'if' and projecting growth but it is just an exercise to point out that the numbers aren't as crazy as it seems. The great difficulty with Netflix is figuring out if their business model is viable. I'm looking into that.

Sivaram - the fact that streaming has grown is what will hurt NFLX. As I've said before, if you are a customer of AMZN prime, basically pay like $80 a year for free shipping, AMZN hooks you up with their video streaming service which has both PPV and free movies/shows. The free portion of AMZN streaming video is pretty much the same junk, lower value content, that NFLX streaming offers. If NFLX wants to obtain better content for streaming, they have to pay a lot more to acquire those rights. That will be a huge cash outflow for them. I have NFLX and the streaming is a lot of TV shows, they do get some new things like AMC Walking Dead and Mad Men but then have a lot of stuff from say ABC Family and then a lot of just old but low tier movies. If I want to watch a horror movie, they won't have even old classics like Nightmare on Elm St. from the 80s,they have Killer Clowns from Outer Space...the other big thing is that most of their newer movies were from Starz which pulled the plug after I think this year. So stuff like GI Joe and a few other bigger movies over the past 2 years will not be available to stream. This is all known news but as you say, NFLX valuation at this level is still high relative to a lot of fundamental problems ahead of it.

And these movies are some recent flicks like Date Night and Crazy Heart, stuff that NFLX does not offer in streaming. You can DVR them as well.

No moat, they are prob the worst capitalized to fund new acquisitions of content, and then very likely to have additional churn. If you are switching providers or the providers start advertising through the tv, mail, emails saying he you can get this stuff for free, you will prob drop NFLX. The telcos and cable cos and sat cos are going at it hard so they need any edge to keep or bring on more custoemrs. This means stuff similar to NFLX will be offered and because of that, it will drop the cost and likely incorporate the stuff that is available for streaming on a nominal basis, maybe $1/mo additional to your bill or as in DTV's case free. No need to pay $9-15/mo for NFLX when you can get the same stuff in terms of streaming for free. That's where the growth for NFLX comes from- the streaming - and that growth will probably be ripped away by the big guys.

If people still want the DVDs, that keeps NFLX in the game but they may have to charge less for a product that costs more to deliver. So margins take a hit probably and top line growth grinds down and maybe declines outright. Based on that, valuation multiples contract further and you could be at

I'll add one more thing to Amit's comments. I am a Netflix subscriber currently and mostly using it to play Disney movies for my 2 year old daughter when we need to "babysit" her at restaurants or in the car. This is not unusual, lots of parents have been using the Netflix/Ipad combination for this purpose. Observe the next time you are at a restaurant. Starz (who has exclusive pay tv window rights to Disney until 2016) know the "market power" they have and held out from Netflix for this exact reason.

Technologically, Netflix has no edge over anyone else. I have a friend who works at a VC (and created a cloud service called AudioGalaxy) and is an expert at these technical issues. Here are a few papers describing how one would build a streaming service. If you are techno geek, you'll see this is not rocket science.

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